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Obama’s Glass-Steagall 2.0 Could Crash Financial System

Washington, D.C., January 21, 2010 – President Obama’s
proposal today to bring back 1930s-like separation of commercial and investment
banks, dubbed Glass-Steagall II or Glass-Steagall 2.0, would do little to
prevent the problem of financial institutions being too big to fail. What it
would do is hurt economic recovery, reduce types of financing available to
businesses big and small and give European and Asian financial services firms a
huge competitive advantage over their U.S. counterparts.

The president’s proposed regulation would leave U.S. banks, in
the phrasing of American Enterprise Institute scholar and former Treasury
Department official Peter Wallison, “too big to fail or succeed.” The proposal
puts forth nothing to stop bailouts or modernize bankruptcy laws to make
failure less systemic. Instead it reintroduces a Depression-era structure for
banking used nowhere else in the world. And it does nothing to stop the size or
systemic dangers of the government-created financial giants Fannie Mae and
Freddie Mac that were at the center of the mortgage crisis.

Repeal of Glass-Steagall, which took place in 1999 with the
Gramm-Leach-Bliley law that passed Congress overwhelmingly and signed by
President Bill Clinton, had little to do with the mortgage meltdown at the
center of our economic woes. Neither Bear Stearns nor Lehman Brothers were
affiliated with commercial banks. Goldman Sachs and Morgan Stanley only became
bank holding companies after they got into trouble. As for the
commercial banks that imploded – such as IndyMac, Wachovia, and Washington Mutual
– all went bust “by investing in bad mortgages or mortgage-backed securities,
not because of the securities activities of an affiliated securities firm,”
Wallison, who is also a member of the Financial Crisis Inquiry Commission, has noted.

In fact, the crisis may have been much worse had
Glass-Steagall still been in place. As former President Clinton pointed
out, Glass-Steagall repeal “has helped stabilize the current situation” by
allowing mergers of commercial and investment banks, such as that of Bank of
America and Merrill Lynch, to go “much smoother than it would have been” when
the law mandated a strict separation.

What’s needed is updating of the bankruptcy laws for
commercial banks, investment banks and combined operations, so that
taxpayers are not holding the bag for any of them. Even before the bailouts,
longstanding deposit insurance hazards engendered moral hazard by allowing
depositors to chase the highest interest rate without inquiring at all to the
safety and soundness of the bank.

Government entities and policies that encourage reckless
lending, such as Fannie Mae, Freddie Mac, and the Community Reinvestment Act
also need to be abolished or phased out.

Meanwhile healthy competition and innovation should be
encouraged among all types of financial institutions to get credit to the
entrepreneurs who will jumpstart our economy. Congress should raise limits on
credit unions’ ability to engage in business lending. Community banks should be
allowed to raise capital without going through the onerous accounting mandates
of Sarbanes-Oxley, especially since they already go through stringent audits
from bank examiners. And the Federal Deposit Insurance Corporation should lift
the moratorium preventing retailers such as Wal-Mart, Home Depot, and units of
Berkshire Hathaway form forming their own limited banking operations.

In short, the biggest systemic risk is that of hazardous
government subsidies to and regulation on the financial sector.

CEI is a non-profit, non-partisan
public interest group that studies the intersection of regulation, risk, and
markets.